What is an adjusting journal entry, which ones does my small business actually need at the end of a period, and who is supposed to make them?

What is an adjusting entry, and how does it differ from a correction?

An adjusting entry is a journal entry made at period end so the period carries the income it earned and the expenses it incurred, regardless of when cash is received or paid. The accounting glossary in a U.S. Department of Housing and Urban Development (HUD) handbook for the housing projects it insures describes period-end entries of this kind, which it calls accruals, as made at the end of an accounting period entirely because the books use the accrual basis, for example to record expenses incurred but not paid. The handbook's manual of accounts also uses an adjusting journal entry at the close of the period to take the cost of expired insurance out of a prepayment.

An adjustment is not a correction. A correction fixes something recorded wrongly. The AICPA's Code of Professional Conduct, in its rules for CPAs, lists standard, adjusting and correcting journal entries separately. Keep them apart in your own books too: if period-end review finds a bill coded to the wrong account, post a correction that says so rather than folding it into an adjustment; otherwise the error vanishes and the habit that caused it is never traced.

Why can't invoices, bills and the bank feed finish the period?

They record when things are billed and paid. HUD's glossary defines the accrual basis as the method in which income is recognized when earned, regardless of when cash has been received, and expenses when incurred, regardless of when cash has been paid. So work finished but not yet invoiced, costs incurred before the bill arrives, and payments that cover more than one period leave the period incomplete or misstated until adjusting entries put them right.

Which adjustments does your business actually need?

Answer each trigger question about your own business for the period. A "no" removes the row; working a generic list instead produces entries you don't need and misses the ones you do. The table assumes accrual books, and the next section covers the cash basis.

The rows follow from the accrual basis. HUD's glossary counts amounts owed for goods or services received but not invoiced as accrued liabilities, and defines depreciation as distributing the cost of fixed assets over a period of years. HUD's manual of accounts records income earned but not received, rent received in advance and held until it becomes due, payroll, payroll taxes and interest accrued but unpaid at the end of the period, the accrual of property taxes, and an allowance for receivables estimated to be uncollectible. For stock, the IRS says an inventory is necessary to clearly show income when the production, purchase or sale of merchandise is an income-producing factor.

Three rows need decisions you may not be able to make alone: depreciation methods and useful lives, stock valuation beyond the count, and the bad-debt estimate. Have your accountant set each once, in writing, and those rows become routine. Prepayments, late-billed costs, depreciation and receivable write-offs each have their own full treatment; the table gives enough to screen and to know what to gather.

What changes if your books are on the cash basis?

HUD's glossary defines the cash basis as recording income and expenses in the period when cash is actually received or disbursed, regardless of when the related goods or services were received or provided. That removes the unbilled-work, customer-deposits, costs-not-yet-billed, wages, interest, taxes and bad-debt rows: a deposit is income when it arrives, an unpaid invoice was never income and so cannot go bad, and accruing unbilled work, costs, wages, interest or taxes on cash books would count each item twice, once in the adjustment and again when the cash moves.

Confirm with your accountant how your cash-basis books carry depreciation before dropping the depreciation row. Whether a cash-basis business still spreads a prepayment belongs to the full treatment of prepayments, and whether it must count and carry stock is a tax-method point to settle with your accountant before you drop the inventory row. If your books are on a modified or simplified cash basis that keeps some accrual items, ask your accountant which rows your basis keeps, and screen those rows as above.

Who is supposed to make each adjustment?

Whoever does the arithmetic, the figures belong to the business. The AICPA's Code of Professional Conduct counts accepting responsibility for preparing and presenting the financial statements among management responsibilities, and a CPA who takes that on for a client whose engagement requires independence impairs that independence. For such a client, a CPA meeting the code's general requirements for nonattest services may propose adjusting entries, but before posting them should be satisfied that management has reviewed the entries and understands their nature and their effect on the statements. Apply the same rule whatever your accountant's engagement: nothing reaches your books that you have not read and understood.

Adjustments reach the books by one of four routes; agree the route for each row of the screening table:

Whichever route applies, the accountant can adjust only what they know about. At each period end they need:

• Bank, card and loan balances reconciled to the period end
• Lists of open customer invoices and unpaid bills
• Unbilled time or deliveries, with the agreed rates
• Payroll records for days worked in the period that are paid after it ends
• Invoices for prepayments and for equipment bought or sold
• The stock count, if you hold stock
• Anything the books cannot show, such as a dispute, a customer in trouble or a changed contract

Do adjustments belong at every period end or only at the year end?

Adjust every period whose reports someone relies on. What settles it is who reads your interim reports and what they decide with them:

Assuming the accountant will handle everything at the year end while interim reports are in use is the costly mistake: those reports become unusable for decisions, and the year end turns into rebuilding the year.

What should you still do each period if your accountant sees the file only at year end?

If your accountant dates their entries at the year end (ask them), interim months stay unadjusted unless you adjust them. At each interim period end, post the rows you own under a standing policy, file the support for the rest, and note anything the accountant will need to know. At the year end, ask the accountant to agree standing policies for next year's recurring rows, so fewer entries wait for them.

Where do adjustments sit before the period's reports are final?

When reports go to a lender, investor, franchisor or other outside reader, hold them until the adjustments are made and reviewed, keep each adjustment's derivation and support where you can produce it, and bring the accountant in before those reports go out rather than only at the year end.

If an item that belonged in an issued period surfaces after its report went out, do not slip it quietly into that period: two versions of the period then exist, and nobody can tell which figures the reader was given. How to reissue reports already sent to a lender or other reader is a practice to agree with your accountant, not a rule a standard sets: tell your accountant, agree whether the item is large enough to change the issued figures and how to record it, and if it is, send the reader a revised report marked as revised.

What record should each adjustment leave?

The PCAOB's fraud standard for auditors of public companies, AS 2401, lists among the marks of inappropriate entries those recorded at the end of the period or as post-closing entries with little or no explanation or description, and those containing round numbers or a consistent ending number. It also warns about adjustments to amounts reported in the financial statements that are not reflected in formal journal entries. Give every adjustment what those lack:

• Description. A memo names it as a period-end adjustment and gives its category and period.
• Derivation. The calculation and its inputs are attached or referenced.
• Support. The documents or count from the screening table sit behind it.
• People. The entry shows who prepared it and who reviewed it.
• Next step. The entry says whether it reverses on the first day of the next period or is re-assessed at the next period end.

Make each adjustment a journal entry in the books, never an edit to a report, and never post one to make a report come out as expected: an amount with no derivation or support is easy to post and impossible to defend when someone asks for it.

What does one adjustment look like from start to finish?

This example is on the accrual basis. A consultancy bills a client by the hour at an agreed 90.00 per hour and sends one invoice for March and April work at the end of April.

Trigger. At March 31, "Did you complete work in the period that you have not yet invoiced?" gets a yes: 30 hours logged in March for this client, not invoiced.

Derivation. 30 hours at 90.00 is 2,700.00.

Entry. Posted at March 31:

Record. The memo reads "Period-end adjustment, March: unbilled work, 30 hours at 90.00, reverses April 1", with the March timesheet export and the engagement letter showing the rate attached, and the preparer's and reviewer's names.

Following period. Reverse the entry on April 1, then invoice as normal. The April 30 invoice covers 50 hours, 30 from March and 20 from April, so it is 4,500.00.

April revenue is 4,500.00 less 2,700.00, or 1,800.00: the 20 April hours at 90.00. March keeps 2,700.00. Together they equal the 4,500.00 invoice, so every hour reaches income exactly once, and unbilled receivables returns to zero. Skip the reversal and April shows 4,500.00, the two months total 7,200.00, and a 2,700.00 unbilled balance sits in the books until someone finds it far from its cause.

On the cash basis there is no March entry: the 4,500.00 is income when the client pays.